Tag Archive for: SEC Marketing Rule

Hypothetical Performance Risk Alerts

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As long as you haven’t been living under a rock for the past year, you may have heard that a modernized Securities and Exchange Commission (SEC) Marketing Rule went into effect this past November 2022. These past few weeks, the SEC has charged 10 firms with violating the New Marketing Rule (NMR), and each of the firms charged share a common error: advertising hypothetical performance without establishing and implementing the required internal “policies and procedures reasonably designed to ensure that the performance is relevant to the likely financial situation and investment objectives of the intended audience.”

In this article, we explore the importance of internal policies and procedures—especially as it pertains to hypothetical performance under the NMR.  The adopting release for the NMR notes that hypothetical performance can be useful, and it isn’t banned.  However, firms not only need to document how they are managing the risk of showing returns with “attention-grabbing power”[1] and ensuring those returns are relevant, they also need to be following those internal procedures.

Policies and procedures—and the compliance officers charged with drafting them—may finally be getting the attention they deserve.  All firms claiming compliance with the GIPS standards have comprehensive written policies covering distribution of performance and disclosures, and the vast majority of those firms also have an outside verifier to test that the policies are actually implemented.  One of the key benefits of claiming compliance with these voluntary standards, that goes way beyond marketing objectives, is attributed to those policies and procedures: getting input into the policies across the firm; having relevant training and continuous feedback from independent verifiers; and providing accessibility and consistent application to newcomers across the firm and over time.

Whether firms are claiming compliance with the GIPS standards or not, well-written performance calculation and distribution policies tailored to your firm with input from all departments to ensure relevance and increase firmwide adoption/implementation is an opportunity to raise operational efficiencies, not a cost center.  The inclusion of detailed actual and hypothetical performance requirements in the NMR has created an opportunity for firmwide dialogue in order for your firm to adopt updated regulatory compliance policies that reflect the NMR requirements that aim to ensure performance is relevant.

The NMR emphasized that hypothetical performance is not suitable for broad marketing to a mass audience, and the nine firms charged in September 2023 all included hypothetical performance on their public websites.  At first read, it doesn’t appear these firms took the time for that firmwide dialogue or careful consideration.  If hypothetical performance is an important tool for your firm and relevant to many of your prospective clients, then the appropriate response to these charges isn’t to quit showing hypothetical performance altogether, but to carefully consider the context in which you present such performance figures. With mass audiences, firms can’t make assumptions about individual financial situations or investment objectives or know if the recipients of the performance are sophisticated enough to interpret the information and understand the risks.  Even in one-on-one presentations, it’s important to make sure your firm is documenting and tracking who is receiving hypothetical performance and relevance criteria.  Our recommendation is to not show hypothetical performance on your website to reduce your regulatory risk.

Compliance with these new requirements is paramount, not only to avoid the very real censure, penalties, and other regulatory consequences faced by these firms, but also to uphold transparency and trust within the industry. Investment firms that successfully navigate these changes will be better positioned to provide investors with meaningful and relevant performance information for their financial decisions.

As firms continue to evaluate value-add performance consulting and verification providers, we hope you’ll consider Cascade Compliance.  We can tailor our high-touch personalized professional service, experienced staff, and competitive fees for a best-fit solution for your firm.  For firms already working with another verifier, we will make the transition seamless, so you only notice the extra responsiveness and attention to detail. Cascade Compliance has over 45 years of combined experience working with SEC Regulations, the GIPS standards, and performance.  Our employees have worked with hundreds of firms in the U.S. and abroad.  One of the best parts of working with clients is getting to share expertise and knowledge of best practices across the industry.  Whether you are a client of ours or not, we are here to help you get better at what you do and answer any questions you may have.  Contact us at connect@cascadecompliance.com.

[1] SEC.gov | SEC Sweep into Marketing Rule Violations Results in Charges Against Nine Investment Advisers

A Summer Must-Read: the Latest SEC Risk Alert on the Marketing Rule

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The June 8 SEC Risk Alert isn’t a window into findings-to-date, nor a much-anticipated list of best practices offering clarification.  It is a solid overview of areas at your firm likely impacted by the new Marketing Rule (NMR).  Accept it as a “summer gift”: a quick read to inspire CCOs across the country to double-check key elements of the NMR and allocate some Annual Review testing time to map out your compliance in each of the areas included in the alert.

  • Policies & Procedures – Dates matter. Current SEC examination periods typically cover two years, which includes materials before and after the NMR.  Most firm’s P&P should have been edited to address new requirements, and the SEC’s initial request lists are looking for dates and descriptions of changes.

Recommendation: save redline versions and/or include effective dates in the P&P document.

  • Performance advertising/substantiation/books and records – The SEC reiterated its focus on these areas, so be sure to document, train, and collaborate with professionals at your firm directly responsible for compiling advertising inputs.

Recommendation: reverse training – have performance analysts train compliance on their own desktop policies and procedures and look for ways to continually improve documentation and disclosures; for GIPS compliant firms, reference additional GIPS P&P in your compliance manual.

  • General prohibitions – SEC registrants must be honest, fair, and balanced in your advertisements. As much as we love reading actual examples of violations (there were none included in the risk alert), we wouldn’t want anyone reading this to be made an example. Compliance needs to review not only what’s on the face of the firm’s advertisements, but also reviewing for what isn’t there.  And, where’s the backup?

Recommendation: review your firm’s advertisements with each of the seven prohibitions as a viewing lens. Is it unclear if a statement is a fact or opinion?  Could small edits make it more clear?  Does your firm advertise performance for strategies with no benchmark presented?  If so, what additional material market events need to disclosed to ensure the presentation is fair and balanced?

  • Three new areas of emphasis: Testimonials and Endorsements, 3P Ratings and ADV filings.

Again, no new guidance provided.  The focused summary provided in the risk alert, however, makes revisiting these areas in your firm’s policies, procedures, and everyday practices an excellent idea.

What we are hearing from SEC Consultants right now is: document and defend.  Firms need to know what is in their marketing materials and be able to defend anything that may be different from what is considered standard in the industry.  As your firm goes through this process, please let us know if you have any questions.  We are happy to help!

Cascade Compliance has over 45 years of combined experience working with SEC Regulations, the GIPS standards, and performance.  Our employees have worked with hundreds of firms in the U.S. and abroad.  One of the best parts of working with clients is getting to share expertise and knowledge of best practices across the industry.  Whether you are a client of ours or not, we are here to help you get better at what you do and answer any questions you may have.  Contact us at connect@cascadecompliance.com.

Year-End Marketing Material Updates

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And a new FAQ from the SEC

RIAs across the country are preparing year-end 2022 performance presentations, and for most GIPS compliant firms, it’s time to update annual performance on your GIPS Reports.  Or is it?  Below are four timely Q&As as we kick-off annual verifications and performance examinations.

1) Is it better to send updated GIPS Reports to your verifier at the beginning or end of the verification?

Most verifiers provide an initial request list asking for policies, performance data, and GIPS Reports right from the start. However, many firms prefer waiting right until the end of the verification to update their GIPS Reports, in case there are updates made to a composite that could change year-end statistics.  At Cascade, we’ll work with your preferences, while also making suggestions to make the process more efficient.  We encourage firms to draft GIPS Reports using their best data, generally the performance data being provided as part of the initial request at the beginning of the verification, and send the GIPS Reports along with the performance.  That way, your verifier can triangulate the most up-to-date policies, performance, and GIPS Reports from the beginning.  Firms may have to make an update to their GIPS Reports at the end of the verification, however more general updates can be communicated from the onset of the initial data review, rather than after multiple rounds of open items at the end of the verification.

2) With the new SEC Marketing Rule in effect, can we distribute GIPS Reports as stand-alone performance presentations with just the performance updated by January 31 (and the rest of the statistics provided through 2021)?

Yes.  Only the required time period performance (1-, 5-, and 10 year returns) is required to be updated within 30 days.  However, as stand-alone presentations, GIPS Reports must include 5- and 10-year returns (or since inception returns, if 5 or 10 year returns aren’t available) through December 2022, in addition to annual 2022 performance.  GIPS Reports must also include benchmark performance for the same time periods composite performance is presented.

January 2023 is the first time firms are required to make annual updates to GIPS Reports while also taking the new Marketing Rule into consideration. For firms that distribute GIPS Reports annually to databases, it’s a great time to consider adding a separate table for SEC required performance time periods, if you haven’t already.

3) With the new SEC Marketing Rule in effect, can we leave 2021 performance in GIPS Reports unchanged until our firm’s AUM is finalized and the GIPS Reports are verified, which is usually during February or March, as long as the GIPS Reports are part of a fair and balanced presentation that includes 2022 performance?

Maybe.  Firms may satisfy SEC general prohibitions by documenting procedures for fair and balanced presentations that prominently present SEC required performance time periods, updated through December 2022 by the end of January. It depends on each firm’s appetite for risk, because what a fair and balanced presentation is under the Marketing Rule is still untested.  At a minimum, we would recommend including references from GIPS Reports to performance pages that have been updated through 2022 and to include required performance time periods.

Because of the significant differences between strong 2021 performance and bearish 2022 performance, we also recommend firms not updating their GIPS Reports to be prepared with an answer if an SEC examiner asks why they weren’t updated, since the performance numbers were available.  Even firms that elect not to include the SEC’s required time period performance on their GIPS Reports this year, may want to update just the annual performance (net and benchmark, and optional gross) through 2022 by the end of January.

The fourth and final Q&A below isn’t our own – it’s an FAQ published by the SEC in January, specifically for firms that manage private funds and want to show investment level returns.  Presenting deal level returns to prospective clients net of fees requires firms to make assumptions that aren’t necessarily helpful/meaningful when applied to unrealized gains and losses of individual investments. The SEC knows this and included a statement to that effect in the proposed PF guidance for reporting to existing clients.  The new marketing rule FAQ below emphasizes subjective selection of best performers as a concern when reporting to prospective clients, and it addresses case studies and groups of investments, rather than addressing a complete side-by-side presentation of all gross deal level returns.  A law firm might argue that such a breakdown of every investment return could still be shown gross of fees in support of fund level returns presented both net and gross of fees.  With only three published FAQs, however, we believe the SEC’s decision to not explicitly permit such a presentation speaks volumes.

What do you think?  We’re not lawyers, but we’d be happy to help you with straightforward assumptions and methodologies for allocating management fees to deal level returns and documenting calculations in performance disclosures.

From: SEC.gov | Marketing Compliance Frequently Asked Questions

 Q. When an adviser displays the gross performance of one investment (e.g., a case study) or a group of investments from a private fund, must the adviser show the net performance of the single investment and the group of investments?

A. Yes. The staff believes that displaying the performance of one investment or a group of investments in a private fund is an example of extracted performance under the new marketing rule.[1]Because the extracted performance provision was intended, in part, to address the risk that advisers would present misleadingly selective profitable performance with the benefit of hindsight, the staff believes the provision should be read to apply to a subset of investments (i.e., one or more). Accordingly, an adviser may not show gross performance of one investment or a group of investments without also showing the net performance of that single investment or group of investments, respectively.[2]In addition, the adviser must satisfy the other tailored disclosure requirements as well as the general prohibitions, including the general prohibition against specific investment advice not presented in a fair and balanced manner, when showing extracted performance.[3]

At Cascade Compliance, we believe that every firm deserves personalized, timely service provided by experienced professionals.  Cascade Compliance has over 34 years of combined experience working with SEC Regulations, the GIPS standards, and performance.  Our employees have worked with hundreds of firms in the U.S. and abroad.  One of the best parts of working with clients is getting to share expertise and knowledge of best practices across the industry.  Whether you are a client of ours or not, we are here to help you get better at what you do and answer any questions you may have.  Contact us at connect@cascadecompliance.com.

[1] Extracted performance means “the performance results of a subset of investments extracted from a portfolio.” Rule 206(4)-1(e)(6). See section II.E.5 of the adopting release.

[2] The rule prohibits any presentation of gross performance in an advertisement unless the advertisement also presents net performance. See section II.E.1 of the adopting release. The gross and net performance requirement applies to not only an entire portfolio but also to any portion of a portfolio that is included in extracted performance. See sections II.E.1(a) and (b) and the definitions of gross and net performance in rule 206(4)-1(e)(7) and (10) (“Net performance means the performance results of a portfolio (or portions of a portfolio that are included in extracted performance…”)). The adopting release also states that the rule requires that advisers that show extracted performance must show net and gross performance for the applicable subset of investments extracted from a portfolio. See section II.E.1.a. of the adopting release (discussing gross performance).

[3] The adopting release states that “advisers should evaluate the particular facts and circumstances that may be relevant to investors, including the assumptions, factors, and conditions that contributed to the performance, and include appropriate disclosures or other information such that the advertisement does not violate the general prohibitions…or other applicable law.” See section II.E.1 of the adopting release (discussing the net performance requirement). In addition, it would be considered “misleading under the final rule to present extracted performance in an advertisement without disclosing whether it reflects an allocation of the cash held by the entire portfolio and the effect of such cash allocation, or of the absence of such an allocation, on the results portrayed.” See section II.E.5 of the adopting release (discussing extracted performance).

Exploring and Documenting Consistent Calculation Methodologies

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Exploring and Documenting Consistent Investment Performance Calculation Methodologies

When trying to understand the limits of the SEC Marketing Rules requirements for consistent related account performance calculation methodologies, advice circulating that firms cannot link daily and monthly performance valuations is misguided. Established in 1993, a key objective of the GIPS® Standards 30-year framework, referenced throughout the SEC Adopting Release, is to “ensure uniformity in reporting so that results are directly comparable among investment managers.”¹ In 2022, compliance with the GIPS standards establishes that consistent calculation methodologies and changes over time are not mutually exclusive, and the GIPS standards also set a best practice precedent for documenting prospective methodology changes and keeping the history intact.

In this article, we explore different methodologies over time, among related account performance calculations, and what different methodologies aren’t permitted in the SEC Marketing Rule.

Individual firms are encouraged to raise the bar on a prospective basis as technology permits. The GIPS standards themselves have prospectively changed both valuation and calculation methodology requirements, keeping historical requirements intact. The documentation of historical changes are contained throughout the GIPS Standards, with illustrative provisions 2.A.24 and 2.A.25 included below.

Examples include the transition from quarterly to monthly valuations in 2001, requiring trade date accounting in 2005, and using fair values instead of market values in 2011. A firm’s historical performance is not only still permitted to be shown for GIPS compliant firms using historical methodologies after there is a prospective change in the GIPS Standards, a ten-year record is required to be maintained, and restating historical performance is to be avoided.

Although the SEC Marketing Rule Adopting Release doesn’t prescribe specific valuation periods or calculation methodologies the way the GIPS standards do, the Adopting Release allows for related accounts to contain immaterial differences in performance calculations.  When discussing the ability to include or exclude accounts from the related account prescribed time-period performance, the SEC gives “advisers additional flexibility to present related performance when there may be immaterial differences in performance results depending on the methods of calculation of returns or as between the different prescribed time periods.”²

This guidance indicates that it is permissible to group related accounts that utilizing more than one calculation methodology for performance.  Further, the Adopting Release states that a firm may “use the same criteria to construct any composites to meet the GIPS standards in order to satisfy the ‘substantially similar’ requirement of the Marketing Rule’s definition of ‘related portfolio.’”³ The GIPS Standards require accounts to be included in composites if they are managed to the same strategy, and specifically permit different calculation methodologies between pooled funds and segregated accounts within the same composite. From a discussion in the 2020 GIPS Standards 2.A.164:

“Although a firm must establish a composite-specific or pooled fund–specific calculation policy, that policy may differentiate calculations used for different types of portfolios in the composite. For example, suppose that a firm has a composite that includes pooled funds, which use a daily TWR calculation methodology, and segregated accounts, which use a Modified Dietz return (with revaluations for large cash flows) calculation methodology. The firm may have a different policy for the return calculation methodologies used for pooled funds versus segregated accounts that are included in the same composite. The firm must apply the composite-specific calculation policy consistently, however, based on the return calculation methodology for each type of portfolio in the composite.”

“Policies and procedures should be reviewed regularly to determine if they should be changed or improved, but it is not expected that they will change frequently. A firm must not change a policy retroactively solely to increase performance or to present the firm in a better light. Retroactive changes to policies and procedures should be avoided.”5

Any advice that firms will not be able to link monthly Modified Dietz performance with daily performance may have been taken out of context, perhaps from the following passage from the rule: “… net performance must be calculated over the same time period, and using the same type of return and methodology as, the gross performance.”

This passage requires that gross returns and net returns are presented using the same calculation methodology as one another.  This does not require the methodology used to calculate both net and gross returns to remain the same over a period of time, as discussed above.  For example, the rule prohibits gross performance from being calculated using the Modified Dietz method, if net performance is calculated by linking daily performance, but the rule does not prohibit a portion of the track record for both gross and net returns from being calculated with Modified Dietz, while another portion of both gross and net are calculated by linking daily performance. Another example of a prohibited calculation methodology would be if gross returns were presented as time-weighted returns and net performance was presented as money-weighted returns.

In conclusion, Modified Dietz, Modified Dietz plus subperiod revaluations for large cash flows, and daily valuations are all acceptable methods for calculating time-weighted returns. Linking any of those three methodologies over time as the GIPS standards have evolved (and portfolio accounting system functionality has evolved) is a common practice in almost every GIPS compliant performance record presented over the past 30 years.  There are many unanswered questions when implementing the SEC Marketing Rule, but the permissibility of calculation methodology changes isn’t one of them.  Documentation and disclosure of changes is all part of a consistent calculation methodology for firms to be able to show meaningful performance that spans decades while also being able to adapt as technology continues to advance and performance calculations become more sophisticated.

Cascade Compliance has over 34 years of combined experience working with SEC Regulations, the GIPS standards, and performance.  Our employees have worked with hundreds of firms in the U.S. and abroad.  One of the best parts of working with clients is getting to share expertise and knowledge of best practices across the industry.  Whether you are a client of ours or not, we are here to help you get better at what you do and answer any questions you may have.  Contact us at connect@cascadecompliance.com.

¹Performance Presentation Standards, AIMR, 1993, (p. ix)

²Investment Advisor Marketing, 17 CFR Part 275 and 279, SEC Final Rule, 2021 Adopting Release, (p. 189)

³Investment Advisor Marketing, 17 CFR Part 275 and 279, SEC Final Rule, 2021 Adopting Release, (p. 194)

4GIPS Standards Handbook, CFA Institute, 2020, (p. 90)

5Investment Advisor Marketing, 17 CFR Part 275 and 279, SEC Final Rule, 2021 Adopting Release, (p. 319)

SEC Marketing Rule – Hypothetical & Extracted Performance

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Hypothetical performance and extracted performance are a key point in the SEC Marketing Rule set to take effect on November 4, 2022.  Firms that have previously used model, targeted, projected, and back tested performance need to take special care when presenting such performance to prospective clients.  The new rule is a significant change from what a lot of firms have been previously allowed to do.

Hypothetical performance will only be allowed after November 4, 2022, if the advisor takes specific steps to address its potentially misleading nature. The SEC’s goal with this portion of the rule is to ensure that advertisements containing hypothetical performance are only distributed to investors who have the financial expertise and resources to interpret the data and understand the risks and limitations of these types of presentations.

There is no distinction between retail and non-retail investors in the new rule when considering the sophistication of the audience receiving the hypothetical performance). The only exception to the hypothetical performance rule is one-on-one communications provided in response to unsolicited investor requests or provided to a private fund investor.

What is considered hypothetical performance?

Hypothetical performance is defined as performance results that were not achieved by any portfolio of the investment advisor. Hypothetical performance includes, but is not limited to: model performance, backtested performance, and targeted or projected performance returns.

Model performance includes performance where the advisor applies an investment strategy that is similar to an actual investor account but makes slight changes to the model to accommodate different investor objectives. Computer generated models are included in the definition of model performance. This type of performance was originally described in the Clover Capital No Action Letter.

Backtested performance is performance that has had a strategy applied historically to market data from prior periods when the strategy was not actually used. This includes scenarios where an advisor could backtest performance based on current strategy data and apply it historically either because the manager doesn’t have actual portfolios during the period, or because the manager doesn’t have access to portfolio books and records for the past period.

Targeted and Projected performance reflects an advisor’s aspirational performance goals. These returns reflect an advisor’s performance estimates, often based on historical data and assumptions. Projections of general market performance or economic conditions are not subject to the provision on presentation of hypothetical performance.

What’s New

  1. The advisor must create and implement policies and procedures designed to ensure the performance information provided is relevant to the financial situation and investment objectives of the intended audience of the advertisement. These policies do not need to address each specific recipient’s circumstances but rather the likely investment objectives and financial situation of the advertisement’s intended audience. Being thoughtful in your establishment of policies and procedures that connect your firm’s hypothetical performance as a useful tool for your typical clients is a key step in being ready for November 2022.

What’s Familiar

  1. The performance being presented must be net performance—just like all actual performance beginning November 2022.
  2. An advisor must provide sufficient information to the intended audience to enable them to understand the criteria and assumptions used in calculating the performance. Sufficient information includes details about how the hypothetical performance is calculated and describes any assumptions used.
  3. An advisor must provide (or offer to provide if the audience is a private fund investor) sufficient information that enables the intended audience to understand the risk and limitations of using hypothetical performance in making investment decisions. Risk information should include reasons why the hypothetical performance might differ from actual performance of a portfolio. An example of this would be external cash flow timing. Simply disclosing the possibility of loss is not enough to satisfy this requirement.

Hypothetical Performance Example

Below is sample disclosure language pertaining to risk information for prospective clients and investors to understand the hypothetical performance shown.  Much of the sample language is straight from rescinded SEC no-action guidance, and we expect such guidance to live on in the implementation of the new Marketing Rule.  While there are familiar disclosures below, we encourage firms to be thoughtful in considering the variety of reasons that their hypothetical performance may differ from actual performance.

The presented performance represents hypothetical model results during the measurement time period. As such, these results have limitations, including, but not limited to, the following:

  • model performance may not reflect the impact that material economic conditions and market factors would have had on the adviser’s decision making or on individual clients, or the impact of the timing of actual client cash flows into or out of an actual portfolio;
  • results do not reflect actual trading by specific clients, but were achieved by [describe calculation methodology and material objectives or strategies used to obtain results];
  • model performance does not reflect brokerage commissions, custodian fees, taxes, or any other expenses a client would have paid, and as such, actual investment returns would be lower;
  • how (if) model performance reflects investments that differ from advisory services currently offered; and
  • hypothetical past performance [just like actual past performance] is no guarantee of future results.

One final note on hypothetical that bridges both policies and disclosures pertaining to hypothetical performance: with the new requirement to show related account performance for actual accounts, now more than ever, it is important to have policies and procedures for reviewing actual portfolio performance to results portrayed in a model.  Results that are materially similar will lend credibility to the usefulness and relevance of the hypothetical/model performance.  Alternatively, we recommend firms reconsider using model performance where model results materially differ from the actual results of related accounts, nor can firms use model results as a replacement for doing the difficult work of aggregating related account performance histories.

Extracted Performance

Extracted performance is defined as performance results of a subset of investments extracted from a single portfolio. This type of performance is commonly known as a “carve-out” to firms that comply with the Global Investment Performance Standards (GIPS®). Additional requirements will apply to advisors who present this type of performance.

The advisor must provide, or offer to provide promptly, the results of the total portfolio from which the extracted performance was derived. This is intended to prevent advisors from cherry-picking certain performance results.

Performance that is extracted from a composite of multiple portfolios is not considered extracted performance because it is not a subset of investments extracted from a single portfolio. This type of performance (including carve-out composite performance that complies with the GIPS Standards) is considered hypothetical and will be subject to the hypothetical requirements discussed above.

The final rule does not require a specific treatment for cash allocation in extracted performance. However, it would be considered misleading to not disclose the allocation of cash and the effects of the cash allocation, or the absence of a cash allocation. When crafting disclosures to meet the SEC rule, it’s important to consider the intended audience. For firms claiming compliance with the GIPS Standards,  cash allocations and additional disclosures are required.

With the SEC Marketing Rule, please remember that when performance is shown, firms must show performance as net of fees.  Firms can also show gross of fee performance however, net must be shown in equal prominence.

Read our blog on SEC portability and predecessor performance here.

If you have any other questions regarding the marketing rule, contact us here.

Cascade Compliance has over 34 years of combined experience working with SEC Regulations, the GIPS standards, and performance.  Our employees have worked with hundreds of firms in the U.S. and abroad.  One of the best parts of working with clients is getting to share expertise and knowledge of best practices across the industry.  Whether you are a client of ours or not, we are here to help you get better at what you do and answer any questions you may have.  Contact us at connect@cascadecompliance.com.